📍 TL;DR

• MLNK is a busted IPO from 2021. But the stock has rallied 25% off an all-time low reached last month.

• In the context of a more optimistic market, and a still-reasonable valuation, the gains make some sense.

• But this story looks more questionable the closer investors look, and 2023 looks likely to be a difficult year.

• This isn’t a home run short but there’s a good case for a bearish bet ahead of earnings in March.

  ---

In the last sixteen trading sessions, shares of financial software developer MeridianLink MLNK 0.00 have closed green 14 times. Over that stretch, MLNK has gained 25%.

To be sure, that rally comes after the company hit an all-time closing low. And it comes amid a market incrementally willing to take on risk, and (not coincidentally) a market clearly hoping for a macroeconomic “soft landing” in the U.S. this year.

Even in that scenario, however, it’s not clear that MeridianLink is going to be a big winner. Increasingly, it seems that the market is buying a story that upon closer inspection doesn’t hold up. The recent bounce provides investors an attractive opportunity to bet against that story.

Introducing MeridianLink

MeridianLink provides a software platform for financial institutions that includes solutions for lending, data verification, account opening, and even collections:

source: MeridianLink 10-K

The company primarily targets middle-market institutions (assets between $100 million and $10 billion), and in particular credit unions. Per the 10-K, it counts over 70 of the 100 “leading”

MeridianLink was founded in the 1990s, and then in 2018 was acquired by well-known private equity firm Thoma Bravo. Thoma Bravo merged MeridianLink with CRIF, another player in the space. More acquisitions have followed since: TCI (developer of Decision Lender) and background screener TazWorks in 2020; data analytics play Saylent in 2021, and then StreetShares, which provides software to financial institutions for business lending, last year.

Thoma Bravo took MeridianLink public in July 2021, at an offering price of $26. The P-E firm still owns half the company.

The Bull Case for MLNK

At first glance, the sell-off seems like it could be an opportunity. To at least some extent, both weakness in the mortgage market and negative investor sentiment toward the software space have contributed to the pressure on MLNK almost since the day it went public:

source: finviz.com

Yet mortgage weakness doesn’t necessarily crush MeridianLink’s revenue from that vertical, let alone as a whole. As for the software sell-off, MLNK is not, and was not, some high-flying SaaS play that traded at 20x revenue. Based on 2022 guidance, shares trade at ~15x EV/EBITDA; trailing twelve-month figures suggest a price to free cash flow multiple of roughly 17x.

Those multiples come despite the fact that revenue is still growing, with MeridianLink projecting sales to increase ~6% this year. Those multiples also are based on results delivered in a volatile environment, and there’s room for optimism toward 2023. Most notably, the launch of MeridianLink One, the company’s cloud-based platform, should help gross margins and potentially drive revenue growth.

There’s a story in which the market became far too bearish toward MLNK in 2022, thanks to negative headlines in the lending space and in software, with the stock then seeing accelerated declines in December thanks to tax-loss selling. Investors in 2023 have taken advantage of those factors to drive the stock back to early November levels.

The Revenue Problem

On its face, that argument has merit. But, again, looking closer the bull case starts to weaken.

Let’s start on the top line. The sense might be that a platform like MeridianLink is somewhat insulated from end market disruption. That’s how the subscription model works, and why SaaS (software-as-a-service) was famously described as “better than first-lien debt”

But MeridianLink’s pricing is notably different from most SaaS developers. Subscription fee revenues (87% of the total for the first three quarters of 2022) have a large usage-based component:

Our subscription fee revenues include annual base fees, platform partner fees, and, depending on the product, fees per search or per loan application or per closed loan (with contractual minimums based on volume) that are charged on a monthly basis, which we refer to as volume-based fees. We earn additional revenues based on the volume of applications or closed loans processed above our customers’ contractual minimums.

The company hasn’t broken out what percentage of revenue is usage-based, but it appears to be reasonably significant. MeridianLink offers a marketplace through which partners offer their own services: DocuSign DOCU 0.00, for instance, can offer digital signatures to MeridianLink users. Per the S-1, MeridianLink "generate[s] a material amount of revenues from our Partner Marketplace", and partner revenues are only a portion of the usage-based total.

The freezing of the U.S. mortgage market amid a jump in interest rates has shown how sensitive the company is to volume changes. In 2020, 39% of revenue came from the mortgage market. The proportion dropped to 30% in 2021, suggesting a ~3% increase on an absolute basis. Similar math implies a 17%-18% plunge in that revenue through the first three quarters of 2022, including a ~23% decline in Q3.

The ostensible good news is that, overall, the company’s revenue still is growing. And so other offerings, including consumer and auto lending, are apparently increasing at a mid-teen rate. But similar pressures can threaten those revenue streams, particularly in a recession.

Meanwhile, there’s still some lingering mortgage pressure coming in the first half of 2023, given the market surprised management to the upside in Q1 in particular. And there’s another issue: contract minimums. After Q1, then-chief financial officer Chad Martin said that customers “typically pick a number [for minimums] that is tied to their low point in volume on a seasonal basis”. That low point is going to be lower-than-normal for many (most?) customers re-upping in 2023. Comparisons on that front are likely to be difficult. As discussed on the Q3 2021 call, customers are incentivized to make higher monthly commitments, which in turn drive lower pricing for applications and other transactions.

MeridianLink already is seeing revenue growth decelerate. Guidance for Q4 implies a year-over-year increase of just 2% to 5%. Mortgage headwinds are a factor, certainly — but there may well be more headwinds on the way in 2023. The auto market is not exactly robust, and the outlook for personal lending is uneven. But it’s also quite possible that customers will adjust their minimums to adapt to a lower-volume environment, leading to another year of relatively modest top-line performance.

Profit Margin Questions

Admittedly, at 15x EBITDA, modest top-line growth would seem like enough to keep the stock relatively stable. But it’s not just revenue growth that is a concern here.

MeridianLink’s guidance suggests a 12% to 13% decline in Adjusted EBITDA year-over-year. In fact, growth against 2020 should be in the range of 4% total.

2020 did see inflated margins, admittedly, with the 52% Adjusted EBITDA margin above the company’s long-term plan of 43% to 48%. And management has said that 2022 is an investment year, with the company building out its sales team and working through a backlog of installations at new customers. The launch of MeridianLink One, and the associated move to third-party data centers, should boost gross margins in 2023, though it sounds as if the company plans to reinvest the savings behind the business.

There’s also the question of how impressive the revenue growth is given the relatively sharp increase in spending. Sales and marketing spend jumped 28% through the first nine months of 2022, while revenue rose less than 7%.

How Good Is The Tech Here?

There’s another reason to be skeptical toward recent growth. Since December 2020, MeridianLink has spent more than $250 million on acquisitions. Those acquisitions, per management commentary, don’t necessarily seem to be particularly accretive: StreetShares, for instance, for which the company paid $23 million, is generating annualized sales in the range of $3 million. The late 2020 acquisitions contributed $42 million in incremental revenue the following year.

Still, that spend should have provided some inorganic profit. The largest concern, however, might be why MeridianLink is making these purchases. On Twitter, Tex Capital (an excellent follow and at one point a MLNK bull) got to the crux of the issue:

Tex Capital @texcap5

R&D via M&A can be a sneaky little angle sometimes with software businesses. Looping back here, it’s one of the angles I didn’t fully account for with $MLNK. Generally tends to go unnoticed, but sneakily consumes cash over time.

Tex Capital @texcap5

I find it extremely odd that $MLNK doesn’t get more attention amongst the investor community at ~13x EBITDA… it seems to check a bunch of boxes: just IPO’d, competitively advantaged SaaS business, double-digit organic growth… I’m hoping someone can point to a bear thesis?

11:30 PM ∙ Dec 23, 2022

There’s a sense that MeridianLink’s technology simply isn’t as innovative as management would argue. One Glassdoor review from an engineer titled “Not a place to build a Software Engineering Career” is fairly withering about the company’s tech capabilities. MeridianLink itself wrote in the S-1 that it has outsourced much of its development to India, and the implied priorities of that decision — that sales and costs outweigh product development — are echoed elsewhere.

The aggressive acquisitions, which include ostensible competitors like TCI and CRIF, seem to support real skepticism toward the underlying product. Surely, the company could better spend $250 million if it was truly launching a game-changing cloud platform this year.

Valuation

And if M&A is replacing R&D, then the valuation here looks far less attractive. 15x EBITDA for this kind of growth (and with net leverage of almost 3x) on its own starts to look a little questionable amid growth concerns, but it looks downright expensive if that EBITDA is being inflated by needed spend being redirected to acquisitions. (It’s worth noting that management is still on the lookout for more deals.)

Indeed, one piece of news that has happened during this rally was a downgrade to Underweight from Barclays, which cut its price target on MLNK to $14. Pegging an exact price target here is not particularly easy, given the lack of history and the moving parts, but something toward the low double-digits seems at least reasonable.

2023 results are going to be challenged, and from a ‘feel’ standpoint the current $1.65 billion enterprise value does seem high. It’s not clear from the S-1 precisely what Thoma Bravo paid for MeridianLink back in 2018, but a $315 million term loan plus equity rollover suggests the figure was under $500 million

TCI cost ~$100 million, and CRIF likely in that range. MeridianLink was the leader of that group, but not necessarily to the extent that supports a valuation likely 8x or more those two (indirect) peers. There does seem to be downside here, particularly if broad market sentiment reverses again and/or 2023 results disappoint.

This probably isn’t a short that returns 50%, but a reversal of the recent rally seems a reasonable expectation. With resistance clearly at $18 — less than 10% above Friday’s close — the risk/reward here seems skewed to the downside, and in a short seller’s favor.

As of this writing, Vince Martin has no positions in any securities mentioned.

If you enjoyed this post, clicking the heart button, helps us a lot ❤️

Disclaimer: The information in this newsletter is not and should not be construed as investment advice. Overlooked Alpha is for information, entertainment purposes only. Contributors are not registered financial advisors and do not purport to tell or recommend which securities customers should buy or sell for themselves. We strive to provide accurate analysis but mistakes and errors do occur. No warranty is made to the accuracy, completeness or correctness of the information provided. The information in the publication may become outdated and there is no obligation to update any such information. Past performance is not a guide to future performance, future returns are not guaranteed, and a loss of original capital may occur. Contributors may hold or acquire securities covered in this publication, and may purchase or sell such securities at any time, including security positions that are inconsistent or contrary to positions mentioned in this publication, all without prior notice to any of the subscribers to this publication. Investors should make their own decisions regarding the prospects of any company discussed herein based on such investors’ own review of publicly available information and should not rely on the information contained herein.